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The Supreme Court's PCAOB Ruling and Wall Street's Self-Regulation

06/29/2010 12:01 pm ET | Updated May 25, 2011

The Public Company Accounting Oversight Board (PCAOB) was created as part of a series of accounting reforms in the Sarbanes-Oxley Act of 2002. PCAOB is composed of five members appointed by the Securities and Exchange Commission (SEC). It was modeled on private self-regulatory organizations (SRO's) in the securities industry -- such as the New York Stock Exchange or the NASD -- that investigate and discipline their own members subject to Commission oversight. The PCAOB is a Government-created entity with expansive powers to govern an entire industry.

Every accounting firm that audits public companies under the securities laws must register with the PCAOB, pay it an annual fee, and comply with its rules and oversight. The PCAOB may inspect registered firms, initiate formal investigations, and issue severe sanctions in its disciplinary proceedings. In a recent lawsuit, Petitioners argued that the Sarbanes-Oxley Act contravened the separation of powers by conferring executive power on PCAOB members without subjecting them to Presidential control. The basis for petitioners' challenge was that Board members were insulated from Presidential control by two layers of tenure protection:

  1. Board members could only be removed by the SEC for good cause, and
  2. the SEC's Commissioners could in turn only be removed by the President for good cause.

On June 28, 2010, the United States Supreme Court held in Free Enterprise Fund et al. v. Public Company Accounting Oversight Board et al. that Sarbanes-Oxley unconstitutionally restricted the President of the United States in his ability to remove a principal government officer, who is in turn restricted in his ability to remove an inferior officer, even though that inferior officer determines the policy and enforces the laws of the United States. Pointedly, the Court held that without the ability to oversee the PCAOB, or to attribute the PCAOB's failings to those whom he can oversee, the President is no longer the judge of the PCAOB's conduct. He can neither ensure that the laws are faithfully executed, nor be held responsible for a PCAOB member's breach of faith. If this dispersion of responsibility were allowed to stand, Congress could multiply it further by adding still more layers of good-cause tenure. Such diffusion of power carries with it a diffusion of accountability; without a clear and effective chain of command, the public cannot determine where the blame for a pernicious measure should fall.

FOR A COMPREHENSIVE DISCUSSION AND ANALYSIS OF THIS CASE:Free Enterprise Fund et al. v. Public Company Accounting Oversight Board et al. at http://www.brokeandbroker.com/index.php?a=blog&id=464

Some folks are puzzled by the seemingly esoteric nature of the Court's ruling. How often would this issue of needing to fire one of these inferior government officers arise? More to the point, isn't this simply a fair delegation of power -- and, even more to the point, don't such inferior officers tend to perform their jobs with diligence?

In answering such questions, I note the following language in the Supreme Court's Opinion:

After a series of celebrated accounting debacles, Congress enacted the Sarbanes-Oxley Act of 2002 (or Act), 116 Stat. 745. Among other measures, the Act introduced tighter regulation of the accounting industry under a new Public Company Accounting Oversight Board. The Board is composed of five members, appointed to staggered 5-year terms by the Securities and Exchange Commission. It was modeled on private self-regulatory organizations inthe securities industry -- such as the New York Stock Exchange -- that investigate and discipline their own members subject to Commission oversight.

At 561 U.S. ___ (2010), page 3

In further comparison to SRO's, the Court explains the following:

The Act places the Board under the SEC's oversight,particularly with respect to the issuance of rules or the imposition of sanctions (both of which are subject to Commission approval and alteration). §§7217(b)-(c). But the individual members of the Board -- like the officers and directors of the self-regulatory organizations -- are substantially insulated from the Commission's control. The Commission cannot remove Board members at will, but only "for good cause shown," "in accordance with" certainprocedures. §7211(e)(6).

Those procedures require a Commission finding, "on the record" and "after notice and opportunity for a hearing," that the Board member

"(A) has willfully violated any provision of th[e] Act, the rules of the Board, or the securities laws;
"(B) has willfully abused the authority of that member; or
"(C) without reasonable justification or excuse, has failed to enforce compliance with any such provision or rule, or any professional standard by any registered public accounting firm or any associated personthereof." §7217(d)(3).

Removal of a Board member requires a formal Commission order and is subject to judicial review. See 5 U. S. C. §§554(a), 556(a), 557(a), (c)(B); 15 U. S. C. §78y(a)(1).Similar procedures govern the Commission's removal of officers and directors of the private self-regulatory organizations. See §78s(h)(4). The parties agree that the Commissioners cannot themselves be removed by the President except under the Humphrey's Executor standard of "inefficiency, neglect of duty, or malfeasance in office," 295 U. S., at 620 (internal quotation marks omitted); see Brief for Petitioners 31; Brief for United States 43; Brief for Respondent Public Company Accounting Oversight Board31 (hereinafter PCAOB Brief); Tr. of Oral Arg. 47, and we decide the case with that understanding.

At 561 U.S. ___ (2010), pages 4-5

In referencing Wall Street's SRO's, the Supreme Court presents us with a likely unintentional paradox -- and a troubling one at that.

From September 1999 until January 2005, Salvatore F. Sodano (Sodano) was the Chairman and CEO of the American Stock Exchange ("AMEX"), a quasi-governmental SRO. From 1998 through 2004, the AMEX was a subsidiary of the NASD, Inc. In December 2004, following the sale of the AMEX, Sodano resigned as Chairman and CEO in January and April 2005, respectively. He subsequently became Dean of the Frank G. Zarb School of Business at Hofstra University in New York. In 2007, the SEC approved the consolidation into the Financial Industry Regulatory Authority ("FINRA") of the member firm regulatory functions of the NASD, Inc. and NYSE Regulation, Inc. In 2008, NYSE Euronext acquired the AMEX and re-branded it as the NYSE Amex Equities.

In case you were unaware, in 1999, Frank G. Zarb was Chairman, CEO and President of NASD, Inc.; Richard G. Ketchum was Chief Operating Officer and Executive Vice President of NASD, Inc.; and Mary L. Schapiro was President of NASD Regulation, Inc. In 2004, Mr. Ketchum was General Counsel of the Corporate and Investment Bank of Citigroup Inc., and then became the first chief regulatory officer of the New York Stock Exchange. In 2004, Ms. Schapiro was Vice Chairman of NASD and President, Regulatory Policy and Oversight. Mr. Ketchum is now Chairman and Chief Executive Officer of the FINRA and Ms. Schapiro is the Chair of the SEC. Quite a high-stakes game of musical chairs on Wall Street.

On September 11, 2000, the SEC settled administrative proceedings against the the AMEX (the "September 2000 Order") based upon findings that the SRO failed to support critical customer-protection rules relating to firm quotes and trading ahead. The expectation by the federal regulator was that AMEX would get its house in order.

In 2003, an SEC investigation of the AMEX determined that the exchange had still not enhanced and improved its regulatory enforcement programs as required by the September 2000 Order. Subsequently, the SEC investigated Sodano's alleged failure to comply with the undertakings in the 2000 settlement and to fulfill his responsibilities as an SRO officer.

And then, virtually nothing happens for nearly four years while the SEC did... did what? Alas, I'm not sure what the SEC did because the record appears devoid of anything. To be fair, the SEC was hot on the trail of both Bernie Madoff and Sir Allen Stanford; and let's not forget how the federal regulator was working overtime to buttress all those defenses against the building sub-prime crisis and the ensuing economic tsunami. Yes, that was a heavy dose of sarcasm.

Finally (belatedly, I would suggest), on March 22, 2007 the SEC charged Sodano with failing to enforce compliance with the Exchange Act during his term as the AMEX's Chairman and CEO. You know, that same "term" when the AMEX was a subsidiary of the old NASD, which was in the capable hands of executives such as current FINRA honcho Ketchum and SEC head Schapiro. The SEC alleged that the AMEX's regulatory deficiencies resulted in large part from Sodano's failure to

  • pay adequate attention to regulation,
  • put in place an oversight structure,
  • ensure the regulatory staff was properly trained, and
  • dedicate sufficient resources to ensure that the AMEX was meeting its regulatory obligations.

The SEC alleged that Sodano's inattention to and apparent lack of interest in regulation filtered down the management chain creating an environment in which regulation was not a priority, and, therefore, compliance with the securities laws and the AMEX's rules was not enforced.

Not one to apparently go down without a fight, Sodano's legal team moved to dismiss the SEC's charges based upon the argument that the SEC lacked authority to proceed against him. Citing Section 19(h)(4) of the Exchange Act, Sodano argued that the SEC's authority to sanction him was:

to remove from office or censure any officer or director of such self-regulatory organization [if] such officer or director has willfully violated any provision... willfully abused his authority, or without reasonable justification or excuse has failed to enforce compliance.

Because 19(h)(4) only permitted the SEC to censure or remove a current officer or director, and, Sodano had not been an AMEX officer or Director since April 2005 (some two years before the proceeding was instituted), Sodano argued that the SEC could not pursue him now that he was no longer at the AMEX.

Laugh at Sodano's chutzpah and/or applaud the SEC's valiant effort -- it doesn't matter. Sodano's line of attack was persuasive and an SEC Administrative Law Judge dismissed the case. On August 20, 2007, an SEC Adminstrative Law Judge granted Sodano's Motion and dismissed the charges because he found that 19(h)(4) does not provide for sanctioning a former officer or director. The ALJ noted that Congress has drafted many statutes that impose the ability to sanction individuals formerly associated with any number of entities. However, that was clearly not the case here and the language must be construed as written.

In December 2008, upon reviewing the ALJ's Decision (and probably also feeling the heat of the resulting firestorm of criticism), the Commissioners of the SEC reversed the ALJ's Initial Decision dismissing the proceeding against Sodano and the SEC remanded the proceeding to the ALJ for a hearing to consider the underlying charges against Sodano, which were never reached because the Initial Decision dismissed the proceeding on Sodano's motion for summary disposition.

By way of a quick rewind, remember that this regulatory mess sort of began around 1999, was initially flagged and settled in 2000, sort of reared its ugly head again in 2003, staggered around drunkenly to 2007 when the SEC charged Sodano, and then got sent into a ditch with the ALJ's dismissal in 2008 and the SEC's remand. Then 2008 became 2009. Then 2009 became 2010. Never seems to be much of rush when it comes to regulation.

On February 22, 2010, the SEC published an Order Making Findings Pursuant to Section 19(h) of the Securities Exchange Act of 1934. (In the Matter of Salvatore F. Sodano, '34 Act Release # 61562 ), http://www.sec.gov/litigation/admin/2010/34-61562.pdf . The Order informs us that

Respondent has submitted an Offer of Settlement ("Offer") which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over Sodano and the subject matter of these proceedings, which are admitted, Sodano consents to the entry of this Order Making Findings Pursuant to Sections 19(h) of the Securities Exchange Act of 1934 ("Order"), as set forth below. . .

. . . .

From at least 1999 through June 2004, the Amex had critical deficiencies in its surveillance, investigative, and enforcement programs for assuring compliance with its rules as well as the federal securities laws. These regulatory deficiencies resulted in part from Sodano's failure to take adequate steps to ensure that he and the Amex were meeting their regulatory obligations. As a result of the Amex's failure adequately to surveil for and investigate violations of, and to enforce, certain options order handling rules, the Amex violated Section 19(g) of the Exchange Act. In addition, the Amex failed to furnish accurate records and, as a result, violated Section 17(a)(1) of the Exchange Act and Exchange Act Rule 17a-1. As CEO, Sodano, without reasonable justification or excuse, failed to enforce compliance by Amex's members and associated persons with the Exchange Act, the Exchange Act rules and regulations, and the Amex's own rules, within the meaning of Section 19(h)(4) of the Exchange Act.

. . .

In view of the foregoing, the Commission deems it appropriate, in the public interest and for the protection of investors to issue this Order agreed to in Respondent Sodano's Offer. Accordingly, the Commission hereby finds that Respondent Sodano, without reasonable justification or excuse, failed to enforce compliance with the Exchange Act, Exchange Act rules and regulations, and Amex rules by Amex members and associated persons within the meaning of Section 19(h)(4) of the Exchange Act.

Alas, more whimper than bang. If you didn't catch it, this saga ends with Sodano accepting the Order. What's the point of accepting the Order? Well if you have to ask, it's probably not much -- and, frankly, it's nary a slap on the wrist.

Maybe the Supreme Court got it right? Maybe it's time that we tugged on those ever-lengthening leashes and held more government officers -- principal and inferior ones -- accountable. Maybe its time that we demand more from our government and regulatory officials than going through the motions.

Accepting appointment to a government board or an organization should entail more than surviving a high stakes game of dodgeball. Such service needs to have consequences beyond raising your hand to vote and putting the title on your resume. As I said at the start of this article, some view the Supreme Court's PCAOB pronouncement as addressing rarefied air. I think not. I think that the ways of government, at all levels, including even the so-called quasi-governmental SROs, need far more accountability.

The way of Washington and state politics seems to be that we only fire folks after a disaster hits and their inadequacies are exposed. Of course, no one seemed to care all that much when they hired the crony to begin with. These things only seem to become issues when there is a hurricane or oil gushing onto our coastlines. No wonder there is so much talk about a good, old-fashioned House cleaning... and a Senate cleaning, and a government agencies' cleaning, and state legislatures' cleaning. Hopefully, the sanction for not doing your job in government or at a Wall Street SRO will be a quick kick in the butt out the door, not the measly censure after you've left.

For a comprehensive discussion of the Sodano case, visit:
http://www.brokeandbroker.com/index.php?a=blog&id=316